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Chapter 7
Perfect Competition and the Invisible
Hand
Questions
1. All else equal, does a steep or flat demand curve result in higher social surplus? How does steepness
of supply affect social surplus?
Answer: Everything else equal, a steep demand curve will result in higher social surplus. As can be
seen in the following figures, social surplus (shown by the triangles A and B) is higher in the market
with a steep demand curve.
Similarly, other things remaining the same, social surplus (shown by the triangles A and B) is higher
in a market with a steeper supply curve.
The diagram ab
T bove shows demand
d and supply
s in the textbook
t markket. The increease in the price of
paaper shifts thee supply curvve for textbooks from S1 to S2. At the oldd price of papper consumer
suurplus was A + B + C + E,, producer surrplus was F + G + H, and social
s surpluss was A + B + C +
E + F + G + H. H At the new higher
h f paper conssumer surpluss is A, produccer surplus is B +
price for
F, and social su urplus is A + B + F. Thereefore consumeer surplus andd social surpluus both fell; the
t
im
mpact on prod ducer surplus is ambiguouss.
6. What could explain n why South Korea’s gross domestic prroduct (GDP) per capita inncreased so muuch
fasterr since the 197
70s than Nortth Korea’s GD
DP per capitaa?
Answeer: One of thee factors that could explainn the divergennce between SouthS Korea’s and North
Koreaa’s per capita GDP is the factfa that Southh Korea is a market
m econommy while Norrth Korea is a
comm mand economy y. The price mechanism
m alllocates resouurces in markeet economies to their mostt
efficieent use. It also aligns the inncentives of sellers
s and buuyers. Centrall planners in command
c
econoomies, howev ver, face coorddination and incentive
i probblems. The ceentral plannerr does not fullly
underrstand consum mer wants andd the productiion capabilitiees of every seector of the ecconomy, and it i is
difficuult to providee workers withh appropriatee incentives.
7. In a command econ nomy, a plannning agency sets
s prices forr various inpuuts and final goods.
g In a market
econoomy, supply and
a demand decide
d the pricces of variouss goods. In booth cases, therre is a set of prices
p
operaating in the economy. Thenn why are marrket economiees consideredd more efficient than plannned
econoomies?
Answeer: Although planning ageencies set pricces, they cannnot always acccurately alignn the interests of
buyerrs and sellers or solve the coordination
c p
problem of brringing agentss together to trade.
t Any
indiviidual can onlyy know a smaall fraction off all that is knoown collectivvely and so a planning
p agenncy
cannoot replicate the work of thee invisible hannd. In a markeet economy on o the other haand, the pricee
mechaanism ensures that econom mic agents maake trades thaat are in their best
b interest anda maximizee
sociall surplus.
8. If your professor decided to give all of his students the highest grade in the class, would that affect
your classmates’ incentives to study?
Answer: If every student were given the same grade irrespective of how he or she did on an exam,
students’ incentive to study. Even without studying, a student would be ‘guaranteed’ a higher grade
than he would have received otherwise. Eventually, one can expect students in the class to stop
studying altogether.
9. Sofia, a political science student, thinks that the government should intervene to revive declining
industries like video rentals and print newspapers. The government, she reasons, can resolve the
coordination problem of getting the agents in these markets to trade. Do you agree with her? Explain
your answer.
Answer: Sofia’s reasoning is flawed because declining industries do not face a coordination problem.
A coordination problem results when economic agents with coinciding interests cannot be brought
together to trade. However, in this case, falling demand is responsible for the decline of industries like
video rentals and print newspapers. Even if the government attempted to bring together economic
agents in these industries, it is unlikely that demand for rented videos and newspapers will increase.
10. Are all efficient outcomes also equitable? Explain.
Answer: Equity is concerned with the distribution of resources across society. An efficient outcome is
one that maximizes social surplus. However, maximizing social surplus is not always consistent with
equity considerations. An economy can make the most efficient use of the resources that it has but at
the same time, these resources may not be equally distributed in society.
11. Are there real-world markets that resemble double oral auctions? Suppose you had to organize a
double oral auction for a good that has perfectly elastic demand. Do you expect prices to approach the
competitive equilibrium?
Answer: Double oral auctions are similar to how trading actually works on stock exchanges—traders
announce bids and asks and if they match, a trade is executed.
Double oral auction experiments with many different market variants - including varying the
elasticity of supply and demand and the numbers of buyers and sellers - have shown that the
equilibrium price in the market will be very close to where the supply and demand curves intersect.
So, the price in a double oral auction for a good with perfectly elastic demand is also expected to
approach the equilibrium price.
12. Imagine you are a buyer in a double oral auction with a reservation value of $10 and there is a seller
asking $8.
a. How much will you gain from accepting this offer?
b. If you are the only buyer, and you know that the lowest ask price is $2, should you accept this
offer?
Answer:
a. By accepting this offer, you will gain $2 ($10 – $8).
b. Yes. By accepting this offer, you will gain $8 ($10 – $2). If you choose to accept an offer
from a different seller, your surplus will be lower. By accepting the lowest ask price of $2,
you will maximize your surplus from this trade.
Problem
ms
1. The following
fo diaggram shows thhe market dem mand and maarket supply for fo sweaters. Calculate
C
consuumer surplus, producer surpplus, and sociial surplus in this market.
Answeer: Producer surplus is thee area of trianggle I and is eqqual to ½ x 1000 x (60 – 20) = 2000.
Consuumer surplus is the area off triangle II annd is equal to ½ x 100 x (90 - 60) = 15000. Social surpplus
is the sum of consu
umer surplus and producerr surplus and is equal to 15500 + 2000 = 3500.
2. Look at Exhibit 7.1 in the chapter that shows the reservation values of the buyers and sellers in the
iPod market. Suppose trades are arranged in this market such that everyone can make a trade without
losing money. So, Madeline buys from Fiona at a price of $70, Katie buys from Matt at a price of
$60, Sean buys from Adam at a price of $50 and so on.
Reservation Values of Buyers and Sellers in the iPod Market
Buyers Value($) Sellers Cost ($)
Madeline 70 Tom 10
Katie 60 Mary 20
Sean 50 Jeff 30
Dave 40 Phil 40
Ian 30 Adam 50
Kim 20 Matt 60
Ty 10 Fiona 70
Since everyone who wants an iPod obtains one, and everyone who wants to get rid of their iPod sells
it at the price they wanted, is social surplus maximized in the market?
Answer: When trades are arranged in the market such that the buyer’s reservation values are matched
with the minimum price that the sellers are willing to accept, the social surplus in the market is equal
to zero. For example, Madeline buys an iPod from Fiona for $70. Since this is the maximum that
Madeline was willing to pay and the minimum that Fiona was willing to accept, there is no producer
surplus or consumer surplus from this trade. This will hold for all the trades between the other
participants and the social surplus will be zero.
Buyers Value($) Sellers Cost ($)
Madeline 70 Fiona 70
Katie 60 Matt 60
Sean 50 Adam 50
Dave 40 Phil 40
Ian 30 Jeff 30
Kim 20 Mary 20
Ty 10 Tom 10
3. There are four consumers willing to pay the following amounts for an electric car:
Consumer 1: $70,000 Consumer 2: $20,000 Consumer 3: $80,000 Consumer 4: $40,000
There are four firms that can produce electric cars. Each can produce one car at the following costs:
Firm A: $30,000 Firm B: $60,000 Firm C: $40,000 Firm D: $20,000
Each firm can produce at most one car.
Suppose we wanted to maximize the difference between consumers’ willingness to pay for electric
cars and the cost of producing those cars, i.e., we wanted to maximize social surplus.
a. How many electric cars should we produce?
b. Which firms should produce those cars?
a. Use
U the figure to complete the
t table beloow:
Befo
ore Income Ro
ose After Income
I Rose Chaange
Co
onsumer Surp
plus
Prroducer Surplus
So
ocial Surplus
b. Use
U your answ
wers to part (a) of this problem to answeer the followinng questions:
i. Did coonsumer surpllus definitely rise, definitely remain connstant, definittely fall, or is the
directiion of the chaange in consum
mer surplus unclear?
u
ii. Did prroducer surpluus definitely rise,
r definitelyy remain constant, definiteely fall, or is the
t
directiion of the chaange in produccer surplus unnclear?
iii. Did so
ocial surplus definitely
d risee, definitely reemain constannt, definitely fall, or is the
directiion of the chaange in social surplus uncleear?
Answer:
a. The completed table is as follows:
Before Income Rose After Income Rose Change
7. The following tables show a small firm’s long-run average cost of manufacturing a good at two
different plants:
Plant 1
Quantity Total Cost Average Cost Marginal Cost
1 50
2 106
3 164
4 224
5 287
6 355
7 430
8 520
9 618
Plant 2
Quantity Total Cost Average Cost Marginal Cost
1 20
2 52
3 90
4 130
5 175
6 227
7 285
8 345
9 407
Answer:
a.
Plant 1
Quantity Total Cost Average Cost Marginal Cost
1 50 50.00 50
2 106 53.00 56
3 164 54.67 58
4 224 56.00 60
5 287 57.40 63
6 355 59.17 68
7 430 61.43 75
8 520 65.00 90
9 618 68.67 98
Plant 2
Quantity Total Cost Average Cost Marginal Cost
1 20 20.00 20
2 52 26.00 32
3 90 30.00 38
4 130 32.50 40
5 175 35.00 45
6 227 37.83 52
7 285 40.71 58
8 345 43.13 60
9 407 45.22 62
b. Since the price of the good is $60, profits are maximized when marginal cost of production is
equal to $60 at both plants. This occurs when 4 units are produced at Plant 1 and 8 units are
produced at Plant 2. The firm’s revenue will be 12 x $60 = $720, its total costs will be $224 +
$345 = $569, and it will earn a profit of $720 - $569 = $151.
c. If the firm uses just Plant 2 it would maximize profits by producing just 8 units (since price
equals marginal cost in Plant 2 at 8 units). Its revenue will be 8 x $60 = $480, its cost will be
$345, and its profit will be $480 - $345 = $135.
8. The following
fo figu
ure shows a firm’s marginaal and averagee costs of production.
a. T
The equilibrium
m price in thiis market is $5. At this pricce, does the fiirm earn proffits or is it makking
loosses?
b. Frrom the givenn informationn, can you connclude whetheer the firm is operating in a competitivee
m
market? Explaain your answer.
c. The
T price of th
he good increaases to $8. Hoow does this change
c your answer
a to parrts a and b?
Answeer:
a.. At a price of $5, the firm
m produces 60,000
6 units of
o the good. Itt does not earnn profits or loosses.
nue from 60,0000 units = $3300,000
Total reven
Total costss of producingg 60,000 unitts = $300,000
Since totall costs = total revenues, proofits are equaal to zero.
b.. Firms in co
ompetitive markets
m earn zeero economicc profits in thee long run. Att a price of $55, this
firm earns zero econom
mic profits. Soo from the givven informatioon, we can coonclude that thhe
firm may be
b operating in
i a competitiive market.
c.. If the mark
ket price increeases to $8, thhe firm will produce
p 80,0000 units of thee good.
Total reven
nue from 80,0000 units = $6640,000
Total costss of producingg 80,000 unitts = $440,000
Since total revenuee exceeds totaal costs by $2200,000, the firm
fi earns ecoonomic profitss. In the long run,
competitive firms earn
e zero ecoonomic profitss. This firm makes
m positivee economic prrofits when thhe
price is $8. This is however, nott sufficient too conclude thaat the firm is not
n operating in a competitive
markeet. This firm might
m be operrating in the short
s run wheere new firms have not enteered the markket
and coompeted awaay its profits.
a. Use
U the figure to complete the
t table beloow
Befo
ore Rent Conttrol After Rent
R Control Chaange
Co
onsumer Surp
plus
Prroducer Surpllus
So
ocial Surplus
b. Use
U your answ
wers to part (a) of this problem to answeer the followinng questions:
i. Did coonsumer surpllus definitely rise, definitely remain connstant, definittely fall, or is the
directiion of the chaange in consum
mer surplus unclear?
u
ii. Did prroducer surpluus definitely rise,
r definitelyy remain constant, definiteely fall, or is the
t
directiion of the chaange in produccer surplus unnclear?
iii. Did so
ocial surplus definitely
d risee, definitely reemain constannt, definitely fall, or is the
directiion of the chaange in social surplus uncleear?
Answer:
a. The completed table is as follows:
As can be seen in the figure, the incrrease in demaand and decrease in supply have actuallyy
increased the
t equilibriuum price from m P to P’. The equilibrium quantity
q shouuld also have
increased from
f Q to Q’. The distancee between Q0 and Q1 show ws the extent by
b which dem mand
exceeds su
upply as a resuult of the pricce control.
b.. An increasse in demand combined wiith a decreasee in supply im mplies an increease in price.
Therefore, to fix this prroblem, the caab fare must be
b allowed to increase. Forr the market too be
in equilibrrium, fares muust be allowedd to increase to P’. At this price, quantitty supplied will
w
equal demand at the quaantity demandded.
See htttp://www.economist.com//node/215515537 and
http:///www.theatlaantic.com/inteernational/archhive/2013/01/its-harder-thhan-ever-to-caatch-a-cab-in--
beijinng/267239/
12. The following
fo quote is from a section on foood shortages inn a book on thhe Soviet ecoonomy:
"Why there is no fiish ... I can't imagine,"
i wroote one indignnant citizen too Anastas Mikkoyan, head of
o the
Food Ministry, in 1940.
1 "We haave seas, and they are still the same as before,
b but theen you could have
y wanted off whatever kinnd, and now I have even foorgotten whatt it looks like."
as muuch [fish] as you
Industries and agriiculture in thee former Soviet Union were state-controolled and the economy’s
e
resourrces were allo
ocated by a ceentral agencyy, Gosplan. Inn the above paassage, the citizen cannot
underrstand why there is a shortaage of fish altthough the coountry possessses the same resources
r thatt it
did beefore the econ
nomy transitiooned to centraal planning. What
W could exxplain this ouutcome?
Answeer: The shortaage of fish coould be explaiined by the faact that the economy was centrally
c plannned.
A cenntral planningg agency is unnlikely to corrrectly estimatee the demandd for various goods,
g in this case,
fish. It
I is also not likely
l to be abble to match production
p caapabilities witth the econom
my’s resourcess. In
other words, since central plannning agencies cannot repliccate the work of the invisibble hand,
mismmatches betweeen demand annd supply are likely to exisst in the econoomy.
From: Everyday Sttalinism: Orddinary Life in Extraordinar
E ry Times: Sovviet Russia in the 1930s (Shheila
Fitzpaatrick)
The following works will be found useful for further study of this
portion of the subject:—
F. M. Balfour, Comparative Embryology, vol. i. pp. 186–241.
F. Blochmann, Ueber die Entwickelung von Neritina fluviatilis Müll.:
Zeit. wiss. Zool. xxxvi. (1881), pp. 125–174.
L. Boutan, Recherches sur l’anatomie et le développement de la
Fissurelle: Arch. Zool. exp. gén. (2) iii. suppl. (1885), 173 pp.
W. K. Brooks, The development of the Squid (Loligo Pealii Les.):
Anniv. Mem. Bost. Soc. Nat. Hist. 1880.
„ „ The development of the oyster: Studies Biol. Lab.
Johns Hopk. Univ. i. (1880), 80 pp.
R. von Erlanger, Zur Entwickelung von Paludina vivipara: Morph.
Jahrb. xvii. (1891), pp. 337–379, 636–680.
„ „ Zur Entwickelung von Bythinia tentaculata: Mitth. Zool.
Stat. Neap, x. (1892), pp. 376–406.
H. Fol, Sur le développement des Ptéropodes: Arch. Zool. exp.
gén. iv. (1875), pp. 1–214.
„ Etudes sur le développement des Mollusques.
Hétéropodes: ibid v. (1876), pp. 105–158.
„ Etudes sur le développement des Gastéropodes pulmonés:
ibid. viii. (1880), pp. 103–232.
H. Grenacher, Zur Entwickelungsgeschichte der Cephalopoden:
Zeit. wiss. Zool. xxiv. (1874), pp. 419–498.
B. Hatschek, Ueber Entwickelungsgeschichte von Teredo: Arb.
Zool. Inst. Univ. Wien, iii. (1881), pp. 1–44.
R. Horst, On the development of the European oyster: Quart.
Journ. Micr. Sc. xxii. (1882), pp. 339–346.
E. Korschelt and K. Heider, Lehrbuch der vergleichenden
Entwickelungsgeschichte der wirbellosen Thiere, Heft iii. (1893), pp.
909–1177 (the work is in process of translation into English).
A. Kowalewsky, Embryogénie du Chiton polii avec quelques
remarques sur le développement des autres Chitons: Ann. Mus. Hist.
Nat. Mars. Zool. i. (1883), v.
E. Ray Lankester, Contributions to the developmental history of
the Mollusca: Phil. Trans. Roy. Soc. vol. 165 (1875), pp. 1–31.
„ „ Observations on the development of the pond-snail
(Lymnaeus stagnalis), and on the early stages of other Mollusca:
Quart. Journ. Micr. Sc. xiv. (1874), pp. 365–391.
„ „ Observations on the development of the Cephalopoda:
ibid. xv. (1875), pp. 37–47.
W. Patten, The embryology of Patella: Arb. Zool. Inst. Univ. Wien,
vi. (1886), pp. 149–174.
M. Salensky, Études sur le développement du Vermet: Arch. Biol.
vi. (1885), pp. 655–759.
L. Vialleton, Recherches sur les premières phases du
développement de la Seiche (Sepia officinalis): Ann. Sc. Nat. Zool. (7)
vi. (1888), pp. 165–280.
S. Watase, Observations on the development of Cephalopods:
Stud. Biol. Lab. Johns Hopk. Univ. iv. (1888), pp. 163–183.
„ „ Studies on Cephalopods: Journ. Morph. iv. (1891), pp.
247–294.
E. Ziegler, Die Entwickelung von Cyclas cornea Lam.: Zeit. wiss.
Zool. xli. (1885), pp. 525–569.
CHAPTER VI
RESPIRATION AND CIRCULATION—THE MANTLE